Options on the cards for life insurers

Options on the cards for life insurers

Mumbai: In a move that could change the way life insurance companies do business in India, the industry regulator is set to allow life insurers to invest in equity derivatives.

To start with, the Insurance Regulatory and Development Authority, or Irda, will allow insurers to invest up to 5% of their equity portfolio in futures and options, or F&O. So far, they have been allowed to invest only in the cash market.

Once they are allowed to invest in equity derivatives, insurers will be able to hedge their equity exposure and protect returns for policyholders.

At present, for traditional policies, life insurers are allowed to invest 50% of their funds in government securities, 15% in infrastructure-related projects, and the balance 35% in so-called other-than-approved instruments, consisting of equities, mutual funds and other money market instruments. For unit-linked insurance products, or Ulips, insurers can invest their entire corpus in equities.

This means that for traditional insurance plans, insurers can invest up to 5% of their other-than-approved portfolio in derivatives. For Ulips, the investment limit will be 5% of the entire portfolio.

“We are working on the guidelines to allow life insurance companies to invest in equity F&O. The guidelines will be ready well within a month," R. Kannan, member (actuary), Irda, told Mint on Thursday.

According to him, the companies would be allowed to invest up to 5% of their investments in other-than-approved instruments in equity derivatives at the first stage. “We need to examine various risks associated with derivative investments while framing guidelines for such exposure to these instruments," Kannan said.

The value of equity derivatives is based on the value of a given equity or an index, pre-decided between the buyer and the seller of the contract, depending on the expectation of the price movement of the underlying instrument on the date of delivery. Options are derivatives which give the buyer of the contract the right to sell the contract on a future date at a price decided today.

Through these, insurance firms will be able to protect their equity portfolio from market falls. It’s a form of insurance against a negative event that may cause prices to fall.

Take the example of an insurance company that has invested in equity shares. While it is convinced about the long-term prospects of these shares, it wants to protect itself against the short-term risk of a fall in the markets, which could erode the value of its portfolio and hurt investor confidence.

One option it has in the Indian market to hedge its portfolio against market risk is to sell Nifty futures. If the market falls, it will make a profit when it buys back the futures at a lower price, negating the impact of the fall in the value of its portfolio. It could also buy a Nifty put option by paying an option premium, which gives it the right to sell the Nifty index at a predetermined price.

Again, if the market falls, it has locked into a contract that allows it to sell at a predetermined price, which enables it to negate the impact of the fall in the value of its portfolio.

Buying a put option entails a fixed cost for the hedging—the option premium. With selling futures, the cost can vary depending on how the market performs. If the market rises, the losses on the short futures position can be huge, and can entirely negate the gains in the underlying value of the portfolio. This is assuming that the entire portfolio has been hedged.

There are 22 life insurers in India currently, with a total investment of Rs2.67 trillion in equities. Life Insurance Corp. of India (LIC) is the largest life insurer with total assets worth at least Rs8 trillion. The state-owned insurer has earmarked investments worth Rs50,000 crore in equities for the fiscal year ending March.

The proposal by Irda “will certainly broad-base the basket of investment opportunities", said V. Vaidyanathan, managing director and chief executive officer of ICICI Prudential Life Insurance Co. Ltd, the life insurance arm of India’s largest private sector lender, ICICI Bank Ltd. “This will lead to some automatic balancing between risks and returns from equity investments."

Nirakar Pradhan, chief investment officer at Future Generali India Life Insurance Co. Ltd, said derivatives were a necessity for the industry.

“About 70-80% of the industry has investments in Ulips, where companies go long in equity investments. Often the returns from equity investments suffer due to market volatility. If we are allowed to invest in derivatives, we can buy put options to hedge our equity portfolio against fall in investment values," he said.

Ulips, where the premium money is predominantly parked in equities, run a high risk of erosion in returns due to market volatility.

Though the investment guidelines for equity derivatives would be coming from Irda after years of debate, S.B. Mathur, secretary general, Life Insurance Council, the representative body of Indian life insurers, said the benefit of such a move will depend on the exposure limit that would be permitted by the regulator.

At present, 179 stock derivatives are traded on the National Stock Exchange (NSE), while 85 such instruments are traded on the Bombay Stock Exchange (BSE).

To start with, Irda may allow insurers to invest in only a few equity derivatives. “Indian products are not very complex and the insurers are likely to be equipped to take exposure in derivatives, but the absorption of the facility will depend on the risk mechanisms within the guidelines," Mathur said.

Market experts said the entry of insurance firms into derivatives trading will help in improving the trading volumes of equity derivatives on the exchanges. The total turnover of equity derivatives on NSE was Rs13.8 trillion during October. BSE had a negligible volume of derivatives trade.

Motilal Oswal, chairman and managing director of Motilal Oswal Financial Services Ltd, said that if insurers are allowed to enter the derivatives market, it will not only improve liquidity and volumes, but also reduce market volatility due to greater participation.

“Such investments are allowed in many markets elsewhere. Insurers will be able to generate additional income if derivative investments are allowed," he said.

Sashi Krishnan, chief investment officer, Bajaj Allianz Life Insurance Co. Ltd, said the industry is well-equipped to deal with investments in equity derivatives. “It will help us to take a view on market direction and hedge our portfolio. It will throw up opportunities for further product innovation," he said.